Chalk Talk: Tax Investing


 

 

Hi, this week in Chalk Talk we’re going to talk about the difference between tax efficient investing and tax inefficient investing. As you can see here, I’ve got a little chart up here, illustration might be a better way to say it.

 

Let’s imagine that you have an investment that’s very tax efficient, and by the way, big difference between financial advisors here because a lot of financial advisors, I shouldn’t say a lot, some pay attention to that, but not many do. Very few advisors actually pay attention to taxes and how it impacts the results of your investment outcomes.

 

So here we go. Let’s say you’ve got $100,000, and you earn 7% over a 20 year period, right? So 7% over 20 years, and you are investing that money in such a way that it is tax efficient. So it’s very clean when it comes from a tax perspective.

 

You could see $100,000, done properly, easily grow to $386,000, in other words, almost four times. Well, that makes sense because the Rule of 72 says you, take your investment return, 7%, you divide it into 72, and that tells you how long it takes your money to double. So seven into 72 says, well your money doubles every 10.2 years or something like that. You say, “Okay, well 10 years, $100,000 grows to $200,000 and then $200,000 to $400,00.” That makes sense. It’s pretty close, right? So $100,000 to $386,000. That’s cool. We love that. That’s beautiful.

 

Now here’s the question. How does or how do taxes affect these outcomes? I mean, if you think about it, very few advisors pay attention to this. They just kind of invest the money and hope for the best. Well, let’s assume, for the sake of discussion, that here we have investment manager B, who’s not so tax efficient, and they earn the same 7%. They invest for the same 20 years, but they’re just not quite as good with the tax side. In other words, they got to pay some taxes as they go. They’re just not paying attention to stuff.

 

It is very typical that during that exact same time period … The question is, okay, how much of an impact might that have? I mean, here we’re at $386,000 by the person that’s very tax efficient. How much of an impact could it really have? While it’s not uncommon, when we did the math recently, we said, “You know what? This guy who’s not really paying attention to taxes and invests like a normal investment firm does, they end up with to $278,000. In other words, that’s about $100,000 less. In fact, more than that, over $100,000 lost to the IRS. Money that’s paid out because not paying attention to the impact of taxes.

 

So yeah, I know this seems like … And here’s the problem. This is really important, because here you are at home. You’re trying to figure out, okay, well what’s the big difference? When you look at two accounts, like account number one and account number two, and you look at history, how have they done? And they both have 20 year histories, and they both say, “Look, account number one, earned 7% a year over the last 20 years. Account number two earned 7% the last 20 years.” They earned the same thing. How are you supposed to pick which one to put your money into?

 

If it’s IRA money, it doesn’t matter because taxes don’t matter, but if it’s after tax money, maybe this was an inheritance or you sold a piece of property or maybe you just saved up some money in your savings account, you got $100,000 to invest. If this is after tax money, it matters. 7% is not equal to 7% in an after tax environment. You have to take a look at the tax consequences of what’s going on there.

 

Here’s the problem from your side of the table. It’s really hard. It’s really hard to figure out which manager is investing tax efficiently and which manager is not. Quite frankly, a great question to ask a financial advisor that you’re talking to might be, how do you determine? What process do you use to determine which manager’s investing more efficiently than the other? The answer to that question could really make your decision for you as to which advisor you might want to go with.

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Centennial Advisors